Year upon year, the Islamic finance industry posts stellar growth figures. However, as large Western lenders withdraw from the sector, is Islamic finance in as healthy a shape as the figures suggest? The Banker asks a number of experts in the field what the future holds for sharia-compliant banking.

There has been no shortage of articles written about how Islamic finance is growing at a galloping pace, with its estimated 15% to 20% annual growth rate considerably outstripping that seen in the conventional banking industry. Global Islamic assets held by commercial banks stood at $1.3bn in 2011, but the industry's forecast growth of some 40% over two years will see this figure rise to $1.8bn in 2013, according to research by Ernst & Young.

To put these statistics in perspective, however, it is worth bearing in mind that Islamic finance is growing from a relatively low base; Islamic banking assets account for less than 1% of global banking assets today.

Under scrutiny

In recent years the values that Islamic finance prides itself on have come under scrutiny. Its ethical foundations and the integrity of products purporting to be sharia-compliant have been called into question. Are they merely sharia-compliant by name but not in substance?    

Most recently, the success of the industry was put under intense spotlight by the announcement in October 2012 by HSBC that it was restructuring its subsidiary, HSBC Amanah. With sharia-compliant assets of $16.7bn, HSBC Amanah had been the second largest Islamic window in the world. 

HSBC's restructuring will result in the closure of its Islamic finance operations in the UK, the United Arab Emirates, Bahrain, Bangladesh, Singapore and Mauritius. The bank has announced that it will instead focus its offering on customers in Malaysia, Indonesia and Saudi Arabia. The three countries together account for 83% of HSBC’s Islamic business revenues. Its global Islamic wholesale banking and sukuk capital markets operations, in which HSBC is the market leader, will still be offered through its subsidiary, HSBC Saudi Arabia, in which HSBC has a 49% stake.   

Akin to most Islamic subsidiaries, HSBC Amanah has never provided separate pre-tax profit figures for The Banker's annual Top Islamic Financial Institutions ranking, last published in November 2012, though this report does help to shed some interesting light on the subject.

Western retreat?

The research shows that with the exception of Qatar, where conventional banks are now prohibited from operating an Islamic window, Saudi Arabia and Malaysia remain the only major markets where Islamic banking has a higher return on assets (ROA) ratio than its conventional peers.  

“HSBC is now a glaring example of Western institution retrenchment from Islamic banking, but there have been many quiet downsizings as well – the likes of Allianz Global Investor, BNP Paribas and UBS,” says Humayon Dar, co-founder of Islamic finance advisory firm Edbiz Consulting, who has also served as chief executive of two other high-profile sharia-advisory firms – Dar Al Istithmar and BMB Islamic.  

“They all entered the industry with high hopes but they’ve now gone very quiet, which is unfortunate because Islamic banking gained legitimacy in the eyes of Muslims, primarily because of the [involvement of these institutions]. But while the industry has benefited hugely from their involvement, it has not given these banks many benefits in return, hence why they’ve retrenched from the market.”

UBS set up an Islamic bank called Noriba in Bahrain, which is no longer in the market, while the likes of BNP Paribas and Société Générale have also retrenched. Relatively speaking, HSBC and Deutsche have been more successful.

“I call it the distribution puzzle," says Mr Dar. "These Western institutions haven’t found a really viable model for distributing their products in Islamic markets. Islamic investors tend to trust local players such as Dubai Islamic Bank and Saudi Arabia’s Al-Rajhi and so on.

“However, in countries such as Saudi Arabia, which restricts conventional banks from operating windows in the country, we have seen the likes of Deutsche Bank and HSBC working as part of a joint venture. Those subsidiaries are doing quite well.”

Exit strategy

Indeed, HSBC Amanah will continue providing universal sharia-compliant banking for its Saudi Arabian clients through Saudi British Bank, in which HSBC owns a 40% stake. “Our philosophy is that if we can’t scale up and be in the top five or top 10 in a market, then it’s not worth us staying,” says Rafe Haneef, chief executive of HSBC Amanah Malaysia. 

“The markets that we exited accounted for only 17% of the bank’s Islamic business revenue. And [HSBC chief executive] Stuart Gulliver has brought a lot more discipline to the business, whereby each entity needs to meet the 'five filters' test. After screening the business, we realised that only two markets met the criteria." Mr Gulliver is offloading HSBC's assets in many countries around the world in a bid to cut costs by $2.5bn to $3.5bn and revive profits; the bank has already divested assets in more than 26 countries.

In the press release issued to announce the restructuring, HSBC stated: “This announcement… demonstrates the group’s commitment to driving growth and improving returns by restructuring or exiting businesses that do not meet its investment criteria.”

To date, HSBC has provided limited information about how it plans to wind down its Islamic activities in the affected countries, but Mr Haneef says: “Subject to regulatory approvals, we will hold any existing assets until they mature, but in terms of the liabilities side of the business, each market has its own deadline for closing down any current or savings accounts.”

Core market focus

However, HSBC achieved its 26-branch network nationwide target in Malaysia in December 2012 – a year ahead of schedule. HSBC Amanah Malaysia Berhad obtained approval in 2007 from Bank Negara, Malaysia’s central bank, to set up 26 branches by 2013.

Mr Haneef has attributed the rapid expansion of the branch network to strong demand from both Muslim and non-Muslim customers. “The number of Muslim and non-Muslim customers is almost equal now, and the ratio of retail and corporate clients is almost even in terms of business composition,” he says. The bank’s pre-tax profit surged from RM80m ($25.85m) for the financial year to June 2012 from RM52m a year earlier.

“Retail banking is all about cost control and economies of scale. So it is not a coincidence that retail Islamic banking is performing best in countries with the highest concentration of Muslims,” says Geert Bossuyt, chief executive of Khalij Islamic, an Islamic investment and advisory boutique set up in 2008, which has a presence in the UAE and UK.  

Furthermore, conventional players have faced the challenges of an uneven playing field. For example, UAE regulation states that international banks cannot operate more than eight retail branches, which puts them at a disadvantage against standalone Islamic institutions such as Abu Dhabi Islamic Bank (ADIB) or Dubai Islamic Bank (DIB), which operate a respective 75 and 64 branches in the UAE.

“Local banks such as ADIB are doing very well in their local jurisdictions,” says Mr Dar. “In Malaysia, local players such as Maybank Islamic and CIMB Islamic can also use their conventional infrastructure to sell their Islamic products so they are at a considerable advantage.”   

Indeed, ADIB posted a net profit of Dh1.49bn ($405.6m) in 2012, up 5% on 2011, aided by strong asset growth, which showed a 15.2% annual growth to reach Dh85.7bn. Meanwhile, DIB’s profits grew by 13% in 2012 to Dh1.19bn.

Broken window?

Of course, the downscaling of Western banks’ Islamic subsidiaries has raised a number of questions – foremost among them is the viability of the window model. Again, research from The Banker's 2012 Top Islamic Financial Institutions report revealed some valuable insights. 

Once our research eliminated the Islamic windows for which profit figures were not available, there were 31 fully sharia-compliant foreign-owned subsidiaries left, with total assets of $53.2bn. The aggregate ROA for these 31 subsidiaries is just 0.72%, about half the aggregate ROA for fully sharia-compliant bank holding companies in the ranking.

“My personal view is that Islamic windows will always face challenges as they treat Islamic banking as a product and not a total value position, and they are aligning their Islamic offerings with the main value proposition of the bank which is, of course, conventional. So there is a credibility question here and customers are asking ‘are you an Islamic bank or not?',” says Tirad Mahmoud, chief executive of ADIB.

“The fact that Islamic banks have made significant changes and improvements to their business models and are now able to compete with conventional banks on areas related to customer service and innovation has put a lot of pressure on Islamic windows. Basically if you can walk through the door, why climb through a window?”

In November 2012, ADIB was hailed as breaking new ground for issuing the world’s first hybrid perpetual Tier 1 sukuk (Islamic bond) aimed at boosting the bank’s capital. The structure, in line with Basel III requirements, will raise its Tier 1 capital ratio to 19% from its previous 13.7%.

“For the first time, Islamic banks are able to raise alternative Tier 1 capital according to Basel standards to boost growth,” says Mr Mahmoud. “The fact that an Islamic bank, as opposed to established conventional banks, issued the first hybrid Tier 1 instrument is significant. We believe that ADIB has paved the way for other entities and institutions to raise capital through similar simple and investor-friendly instruments. With the creation of this instrument, I believe we have set a real example of innovation in the field of Islamic finance.”

The rise of sukuk

The sukuk market also reached another milestone in Saudi Arabia in October 2011 when Saudi Aramco Total Refining and Petrochemical Company (Satorp) issued a $1bn project sukuk to finance the planned 400,000-barrels-per-day crude oil refinery in Jubail, estimated to cost more than $13bn. Significant demand led to an oversubscription of roughly 3.5 times. 

As the Middle East’s first public project sukuk, the issuance was important – both symbolically and from a structural point of view. The structure follows the Islamic principle of musharakah and it is not a straightforward debt funding of an existing business, but involves the construction and development of a new asset. It includes a number of banks to fund different aspects of the project in a complex inter-creditor arrangement, and furthermore it is created as a joint venture between two equity investors.

“Greater use of equity-based models in Islamic financial solutions has been observed [more recently],” said Zeti Akhtar Aziz, the governor of Bank Negara Malaysia, Malaysia's central bank, in a speech at the end of 2012. “This has been most evident in the sukuk segment, with sharia-compliant structures evolving from predominantly ijarah and murabaha structures to musharakah partnerships as well as convertible and exchangeable trusts.”  

There are hopes that this will start an important trend in project sukuk, especially to finance planned multi-billion-dollar infrastructure developments. The International Monetary Fund (IMF) has estimated that $800bn will need to be invested in infrastructure projects across the Gulf in the next five years. At a time when the world’s conventional banks are offering fewer and shorter loans, this represents a tremendous opportunity for Islamic finance.

A success story

Indeed, the one aspect of the Islamic finance industry that has enjoyed undisputed success is the sukuk market. While most deal activity remains in the doldrums, Islamic investment banking has bucked the trend, with debt capital markets activity in this area booming. 

The most significant industry trend in 2011 was the sukuk comeback and it has continued to go from strength to strength. It has been characterised not only by the pioneering development of new structures, but also several new entrants to the market, especially from non-traditional issuers, while US dollar-denominated sukuk issuance doubled from $9.5bn in 2011 to $18.4bn in 2012.

This helps explain why HSBC, Royal Bank of Scotland, BNP Paribas and Deutsche Bank have all created separate desks to cater to Islamic structuring. Société Générale, meanwhile, was granted a UAE Islamic banking licence in December 2012.

“We’re not going to be everywhere, but [instead] aim to be more selective,” says David Ishoo Mirzayoo, head of central and eastern Europe, the Middle East and Africa sales, global markets, at Société Générale Corporate & Investment Banking. “We are encouraging European investors to tap the sukuk market to diversify their source of funding. The US dollar market is a focus for us going forward and I believe we have all the required structuring capabilities and expertise in Islamic finance to address our clients' needs.”

Furthermore, data from our 2012 Top Islamic Financial Institutions report shows that Citi Islamic Investment Bank (the only global bank to report the results for its Islamic investment bank) registered a 21% ROA in 2011, making it the best-performing foreign-owned subsidiary in the ranking.

Optimistic mood

That is not to say that Islamic investment banks are exempt from earnings volatility, however; of the 24 fully sharia-compliant investment banks in The Banker's ranking whose assets totalled $14.65bn, almost half were loss-making in 2011.

Even so, industry practitioners remain bullish on the market. “When you issue a sukuk, you can attract both conventional and Islamic investors. If you’re a conventional institution that’s offering investment banking then I think you’re taking a huge risk by not having an Islamic offering,” says Iqbal Khan, who was a key architect in the founding of HSBC Amanah and is now the chief executive of Fajr Capital.

“I sit on the investment committee of some of the leading endowments in the region and we’re seeing that the pension funds of large corporates and government agencies are increasingly asking for their money to be managed in a sharia-compliant manner. This means there’s an underlying shift in the industry whereby pools of capital with a long-term maturity horizon will start emerging and we’ll see more long-dated sukuk coming to the fore,” he adds.

“The sukuk industry and corporate markets in general are doing well for the simple reason that Muslim-populated countries are performing well today,” says Mr Bossuyt. “They have a lot of liquidity and investors want to tap into that.”

A sukuk timebomb?

There are others, however, who believe that the rapid growth of the sukuk market and the industry’s dependence on it poses its own risks. “I have some concerns over the future growth of the sukuk market and the fact that Islamic banks have not learnt the lesson from the conventional banking industry,” says Mr Dar.

“In 2012, the industry kept celebrating the fact that it had been a ‘bumper’ year for sukuk but that’s because there has been very little else going on. Globally speaking, there was about $144bn of sukuk issued in 2012, an improvement over the amount seen in 2011, and there is expected at least another $100bn in 2013, which totals about $400bn in sukuk outstanding.

"That is a significant proportion of the total Islamic financial services industry worldwide which is valued at about $1300bn. I think there has become an over-reliance on this one instrument and if it continues, it will pose a risk to the industry.”

Indeed, the industry is premised on risk sharing rather than risk transfer, but critics of Islamic finance are quick to point out that the majority of sukuk in existence favour the latter. While Satorp’s use of a musharakah structure for its $1bn sukuk was seen as a welcome development, there is a need for more instruments with equity characteristics and most industry practitioners are acutely aware of this.

“Unfortunately, Islamic banking is almost a contradiction in terms because Islamic finance is all about risk sharing, while banking is fundamentally about risk aversion,” says Mr Bossuyt.

Identity crisis

“From a product perspective, we still have a lot of scope for development and it is about time that Islamic banks look into developing them. We need more risk-sharing products as opposed to risk-transfer products. Unfortunately, Islamic banks haven’t been able to shift into that mode, but I think that’s where the industry has been unfairly criticised,” says Mr Haneef.

“Conventional banking has been built to cater to the needs of conventional banks, so if your field has been designed to play rugby then it’s not easy learning how to play football on it. Our response is that it takes time to build the platform and for that the infrastructure needs to change, which could take between 30 and 50 years. It has taken 30 years to get to where we are today and it requires certain changes in the market to change the infrastructure, so my timeline is linked to the market share.”

This over-reliance on the conventional banking framework led Professor Volker Nienhaus, appointed adjunct professor of the International Centre For Education In Islamic Finance in January 2012, to famously argue that the recent trends in the industry are more in line with the conventionalisation of Islamic banking and finance and less on Islamisation of conventional banking and finance.  

Innovation shortfall

On the subject of innovation in the Islamic finance industry, Mr Dar says: “I haven’t seen any really good examples of innovation in the last two years. And that’s because generally speaking, the Islamic banks, and especially the smaller ones, don’t have any budget for innovation so they’re just making cosmetic changes to the conventional products. Deutsche brought about a lot of innovation because they were willing to invest time and money.”

Harris Irfan, former head of Islamic products for Barclays Capital in Dubai and founder of Cordoba Capital, shares the same outlook. “Islamic banks should start being leaders, not followers,” he says. “To date, they have relied on the likes of Deutsche Bank to come up with and sell new product ideas and then they follow suit. Because the likes of UBS, Credit Suisse and now HSBC have all downsized their Islamic operations, we don’t have that innovation coming through anymore. For example, progress on the master hedging agreement has been disappointingly slow over the past few years because the momentum is not there to make it happen.

“In my opinion, the financial crisis has been a wasted opportunity by the Islamic industry. Over the past few years, we’ve been expecting it to accelerate and fill the vacuum that conventional banks have left behind. But that hasn’t happened yet.”

Mr Khan of Fajr Capital adds: “In the wake of the crisis, the Islamic finance industry has been impacted by a declining level of real economy assets. The quest for authenticity is going to be an ongoing challenge. As the financial economy restructures itself, then Islamic institutions will be forced to make choices, and those that choose assets linked to the real economy, to equity modes of financing, will find that they will perform better.”

The places to be

However, the general consensus among leading Islamic bankers is that the Middle East and Association of South-east Asian Nations members will continue to serve as the growth engines of the industry, fuelled by their large pools of liquidity. While north Africa appears to be fertile ground for the industry, the role the Arab Spring countries will play in the growth of the industry remains to be seen.

Ernst & Young forecasts that as new geographies open up, Islamic banking assets in the Middle East and north Africa (MENA) region could more than double from $416bn in 2010 to $990bn by 2015. The MENA region's Islamic banking assets increased to $416bn in 2010, representing a five-year compound annual growth rate of 20%, compared to less than 9% for leading conventional banks.

However, there are significant performance variations across markets – in 2010, the average return on equity of leading Islamic banks declined to 10% and market valuations appear to be converging to that of regional conventional peers.

“The prospect of Islamic finance as a global phenomenon has diminished," says Mr Dar. "Rather, it is emerging as an Organisation of Islamic Co-operation phenomenon – centred around the Gulf markets and Malaysia, and to a lesser extent Indonesia.” 

“So the notion of Islamic finance as an integrating force between the Muslim world and the West is disappearing. In five years’ time, I think it will be a very regional phenomenon and the West will be making a marginal contribution.” 

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